Talk of non-fungible tokens is hard to avoid of late. But why all the fuss? What exactly are they, and what real-world applications do they have? Demystifying this brand-new cryptocurrency will be key to mainstreaming it and ensuring its long-term success.  

The next futuristic technology everyone is talking about are non-fungible tokens (NFTs). This data unit – positioned in a digital ledger, or blockchain – seems to have permeated all walks of life.

In late March, Saturday Night Live aired a comedy rap video – parodying Eminem’s song, Without Me – in which Pete Davidson explains to viewers how NFTs work. The clip has already garnered over two million views on YouTube. At the start of April, two Coinbase employees sealed their wedding vows by swapping NFTs – claiming the gifts would last longer than any ring they could have given each other. Barely a week after that, Playboy’s chief brand officer announced plans to dig into the lifestyle company’s library of classic magazine imagery, and release crypto artwork collectibles as NFTs.

The rate at which the NFT space is moving is truly mind-bending. According to the NFT Report 2020, the NFT market grew by 299% in 2020 – reaching a total value of around $250 million. In 2021, the market is set to continue to grow rapidly, and will likely become a leading driver of economic activity in the digital arena.

With these developments in mind, it is time to take stock of how we got here, ask how the technology itself can be applied usefully in the real world, and explore some of the potential complications associated with NFTs – including their high energy consumption, ownership rights, seller tax, and the speculation bubble.

What are NFTs?

All-in-one card fintech Curve recently tapped the NFT craze by auctioning five pieces of digital art for charity. Curve’s founder and CEO, Shachar Bialick, said: “NFTs hold genuine promise to change how we think about art ownership and enjoyment as a purely physical experience.”

So, what is an NFT? An NFT is a unit of data, positioned on a blockchain. Each NFT can represent a unique digital or physical item, and is therefore non-fungible, i.e. not interchangeable. Simply put, these digital tokens represent certificates of ownership for virtual or physical assets. As such, NFTs are often linked to collectable digital files, including original artworks, songs, or videos.

Having recently launched a platform that helps marketplaces accept credit card and crypto payments for their NFTs, fintech company Circle is also cashing in on the hype. Jeremy Allaire, CEO of Circle, said: "This is not only an important and valuable trend for marketplaces and creators, it represents incredible demand from customers – for collectibles, artwork, moments, and really anything that can be tokenised on the blockchain.”

How do NFTs work?

When a NFT is purchased, the transaction is run through a network of computers that retain a digital record of all trades ever executed for that specific token. This decentralised network is often referred to as a blockchain, which ensures every computer involved agrees with any change to the ledger – as is the case with paper documents, when a car is traded, for instance. When a NFT owner sells their token, a fresh certificate is generated for the new owner – thus confirming the item’s authenticity.

This process ensures maximum security when trading NFTs.

What is cryptoart?

So, why are NFTs so attractive to buyers and sellers of art?

With no tangible form, NFTs are very liquid, while still being unique – making them well-suited for trading all kinds of collectables, including classic cars and watches, as well as art.

Artworks linked to a NFT, via unique metadata, is known as cryptoart, and it is driving interest in art co-ownership. “Traditionally, art has been less liquid than other collectibles”, said Andrea Seminara, CEO of asset management firm, RedHedge, in an interview with Finextra. “Classic cars, for instance, can be easily bought and sold via a dealer. Trading valuable art, on the other hand, is more complicated. However, thanks to NFTs, artists can now sell percentages their work digitally, to any number of buyers, with greater ease.”

Seminara’s asset management firm is pushing this idea forward through their partnership with London Trade Art, on an innovative project that facilitates the trading of art via NFTs. And, just like any other secondary market, London Trade Art’s Art Exchange enables individuals to buy and sell cryptoart contracts online.

If a piece of art is purchased by more than one buyer, a third-party guarantor will store and maintain the piece – facilitating possession among its owners for a portion of the year equal to their individual share. This model enables individuals to diversify their portfolios in collectables, without requiring them to purchase entire pieces.

Until now, the art market has been behind many other sectors – particularly financial services – in terms of technological innovation,” said Seminara. “Today, an art auction house can feel like the trading floor of a stock exchange in the 1990s. However, by deploying NFTs to sell digital and physical artworks, the art sector can modernise and democratise. This is a nexus of opportunity for the financial services and art spheres.” 

What are some of the issues surrounding NFTs?

1. Sustainability

Perhaps one of the most widely discussed cryptoart transactions of late is the sale of Canadian music artist Grimes’ collection of short films, produced by herself and her brother. The NFT-linked videos sold for a staggering $6 million.

This milestone in the emergence of NFTs raises an important question around their environmental impact. According to a recently defunct cryptoart carbon footprint calculator, invented by artist Memo Akten, the sale of Grimes’ video collection consumed as much energy as an average EU citizen would in over three decades.

“The high energy consumption of an NFT transaction is a concern”, said Seminara. “But, herein lies the whack-a-mole effect of sustainability – one solution creates another challenge. To combat this, regular purchasers of NFTs may need to practice carbon offsetting.”

Indeed, as the volume of NFT transactions rises, this issue will need to be addressed, and greener sources of energy will have to be identified. 

2. Ownership rights

Clearly, the music industry has become something of a battleground as NFTs have come to the fore. The question of rights ownership when it comes to an NFT-linked music sale is just as contentious a topic as the energy the transaction consumes.  

In April, a Guardian article pointed out that “despite the clear traceability, there remains enormous uncertainty about just how the rights and ownership of the original creators – from songwriters and producers to session musicians – apply in an NFT sale that includes music.”

Indeed, there have been a growing number of disputes within the music industry lately, whereby artists have sought legal action against the sellers of their NFT-linked music. The common defence from sellers is that, in fact, the experience of owning the original version of the song is being sold, as opposed to the ownership rights themselves.

This is unchartered waters for music lawyers, and it is becoming increasingly challenging for artists to address the issue. Perhaps the industry needs tighter regulations that oblige sellers of NFT-linked music to define the precise terms of each transaction and declare exactly what is being sold. This can of course apply to all NFT sales. 

3. Seller tax

Ownership rights are not the only unexpected snag associated with trading cryptoart. Buyers and sellers of NFTs are likely to be surprised by a steep tax bill on Tax Day.

Mike Winkelmann, for example – who in March sold his work of art, called The First 5,000 Days, via NFTs for a record-breaking $70 million – is rumoured to face taxes in the tens of millions of dollars. When informed on the extent to which he would be taxed on the sale, Winkelmann was shocked.

Currently, the US government treats the selling of NFTs the same as selling stocks. It is a realisation of investment gains, and therefore subject to capital gains tax. Yet, since NFTs are also collectible, they are taxed at an even higher rate, of 28%.

In the United Kingdom, steps have been taken to tackle the uncertainty surrounding NFT taxation, with HM Revenue & Customs (HMRC) publishing their guidance on the taxation of cryptocurrencies, on 30 March 2021. The report, Crypto Assets Manual, goes some way to consolidating previous guidance, and provides a steer on how HMRC will tax transactions of cryptoasset exchange tokens that involve businesses and companies, as well as sole traders.

While this is a positive step, we must remember that the Crypto Assets Manual is merely HMRC’s guidance on the issue, and does not yet represent law, in the eyes of the UK government.

As NFTs become increasingly ubiquitous, taxation laws will need to be tightened in order to instil integrity into the market and give NFT traders confidence on Tax Day.

4. The speculation bubble

Arguably one of the most serious issues threatening the long-term success of NFTs is the prediction that the technology is merely a speculation bubble.

This is no fringe concern. Winkelmann, himself, recently claimed that cryptoart is riding on a crest of speculation and will soon plummet in popularity. He even likened NFTs-linked art to other blue-chip trends, which perform well over time, but eventually peter out.

Seminara disagrees: “Unlike Bitcoin, for instance, NFTs are not a speculation bubble, because they can be linked to truly desirable works of art, in a process that delivers real value to buyers and sellers. So, while the technology itself may evolve, the idea of art co-ownership via NFTs will only grow.”

Only time will tell whether this bubble will pop.

What does the future have in store for NFTs?

Thanks to their unique and non-interchangeable nature, NFTs address some of the art market’s biggest and most longstanding challenges, such as authenticity and co-ownership.

The potential of NFTs, however, extends beyond art, and could be applied to the trading of any tokenisable physical or virtual experience or item.

But before then, NFTs will need to be mainstreamed, and to do so will mean addressing some challenging issues, such as the cryptocurrency’s high energy consumption, and the question of ownership rights, and seller taxation. Clearly, organic growth – with measured regulation – will be key to the long-term ubiquity of NFTs.

If the challenges can be addressed successfully, we may one day see people buying and selling NFTs from their mobile phones – just as we all already do on Amazon.

Naturally, the path ahead is unclear, so we must ensure the NFT craze is steered toward applications that continue to improve people’s lives, and businesses more broadly.